Category Archives: Leverage

The Power of Effective Diversification: Part II

Last week, I posted an article discussing how diversification is one of the most misunderstood concepts in investing. In today’s post I continue with the second half of this two-part series titled, “The Power of Effective Diversification.”

In Part I of this article, I discussed the difference between naive diversification (holding lots of stuff in a portfolio) and real diversification (combining assets in a portfolio to create risk offsets).  I also showed how a well-diversified portfolio can maintain the ability to participate in market rallies while still mitigating risk.  In Part II, we will explore what an effectively diversified portfolio looks like today. Continue reading

Investors’ 10 Most Common Behavioral Biases

Guest post by Contributing Editor, Robert P. Seawright, Chief Investment and Information Officer for Madison Avenue Securities.

Barry Ritholz (of The Big Picture and a Sunday Business columnist at The Washington Post) recently contributed Investors’ 10 most common mistakes to The Washington Post Business Section quarterly investing section. It’s a commentary that he has been working on for a while — the ten topics are listed with links to longer discussions of each common mistake here. I created my own investing “checklist” (here) in response to Barry’s original list. For yet one more iteration of the theme, I offer my list of Investors’ 10 Most Common Behavioral Biases.  There are a number of others, of course, and more will continue to be uncovered.  But I think that these are the key ones. Continue reading

Sector Watch: Low-Beta Stocks

Financial theory suggests that risk and return go hand-in-hand:

Small company stocks tend to be riskier and outperform large company stocks. Long-term bonds tend to be riskier and outperform short-term bonds. Corporate bonds tend to be riskier than Treasury bonds (with comparable terms) and outperform Treasuries over time.

However, there is one group of stocks that has consistently defied this risk/return relationship: Low-beta stocks. A low-beta strategy involves selecting stocks that have a lower-than-average beta value. (Beta is a measure of the stocks’ volatility and adding low-beta stocks to your portfolio can help investors build a diversified portfolio.) The good news for investors here is that Continue reading

The Pension Dilemma

Guest Post by Contributing Editor, Michael Lewitt, Vice President and Portfolio Manager, Cumberland Advisors. We thought this was an interesting article and thought our readers would too. Enjoy.

America’s largest pension fund, the California Public Employees Retirement System (CALPERS), reported a 1% return on its investments for the 12 months that ended June 30, 2012.  This disappointing return fell woefully short of the plan’s target return of 7.5%Continue reading

Emerging Market Indexing

Guest post by Matthew Amster-Burton, Mint.com. We thought this was an interesting article and thought our readers would too. Enjoy.

Let’s say you want to build your own stock market index fund based on the S&P 500. Easy: download a list of all the companies in the index–from 3M (MMM) to Zions Bancorp (ZION) and their market cap, and start investing. Every stock in the index will be easy to buy in whatever quantity you want.

Now, after the success of your first index fund, you decide to create an emerging market fund, concentrating on the world’s up-and-coming economies. Again, no problem. We have the internet, after all, and we can just print off a list of all the stocks in China, India, Chile, Hungary, and so on, pull out a pile of Benjamins, and go to town.

That won’t work, says Raman Subramanian, Executive Director of Index Research at MSCI. Continue reading

Sector Watch: Spotlight on BioTech

The challenge for many investors who are trying to diversify their portfolios is finding sectors or asset classes that don’t move in tandem together. One sector that has moved up—even as many equity indexes have fallen—is biotech.

Performance: Behind the Numbers

Over the past three months, even as the S&P 500 and other broad market indexes have generally suffered  (the S&P 500 is down 0.62% to date) biotech stocks have generated impressive returns. The iShares Nasdaq Biotechnology Index Fund (IBB) is up almost 12.7% over this period, and the Folio Investing Biotechnology Folio is up 22% over this same 3-month period. For the trailing 12-months, the Biotechnology Folio is up 40% and IBB is up 23.8% compared to the S&P 500 which is up only 5.2%. Continue reading

Why Bond Yields Scare Me More Than Friday the 13th

Stock investors generally don’t have much to fear on Friday the 13th. Historically, Friday the 13th is a relatively calm day for stocks. Jason Zweig, who writes The Wall Street Journal’s Intelligent Investor column, says it’s usually a good day for investors and says superstition about trading on this supposedly unlucky day is one of the market’s “dumbest myths.”

Bond yields, however, are seriously worrying to Geoff Considine.  Here’s why. Continue reading

The Facebook IPO: Why Gambling with Your Portfolio Rarely Pays Off

In the academic finance world, it’s fairly common to find comparisons of investors to gamblers and certain types of stocks have been referred to as ‘lottery tickets.’ I’ve found that this comparison is actually quite important. There is an odd paradox between the assumption that investors are rational when it comes to investing, yet still spend an awful lot of money playing the lottery.  When we speak of “lottery ticket” investments, we are talking about investments that have a small probability of a big “win” and a large probability of a modest “loss.” And this is precisely the situation with lotteries.

The reality is that people spend considerable sums of money on lottery tickets, a money gamble that has a negative expected value. This same appeal (big, low-probability win, modest high-probability loss) also seems to motivate some investors. Continue reading

Stocks and Shocks: What to Do?

Guest Post by Contributing Editor, David Kotok, Chairman and Chief Investment Officer, Cumberland Advisors.

How do we avoid walking into a “left hook” in the markets? That was the discussion this week during a client review.

“Can’t you see them coming and avoid them?” he asked. Well maybe some folks can, but the issue of investing with possible shocks as an outcome is a very difficult one.

“Do you position for the worst outcome?” If yes, you would never invest in anything.

“Is there a middle road?” We think so and that is why we use a combination of ETFs and bonds and recommend diversifying risk among several asset classes.

Below this introduction is a partial list of upcoming potential shocks. As readers will note, we can see the potential shock relatively clearly. Scott MacDonald of MC Asset Management calls them “dangerous seas ahead.” His maritime metaphors sequence the Titanic and Lusitania. Lehman-AIG and the meltdown were the Titanic. “This leaves us to wonder if the U.S. economy is not like the Lusitania, operating in a high risk environment, but felt to be safe from prowling German U-boats in the North Atlantic.” ponders Scott.

Of course, we cannot know the result of a potential risk before it happens. We cannot know the outcome and the policy shift. Therefore, the anticipatory period preceding the risk and the aftermath (if as and when the risk is realized) are not symmetrical. In other words, you are investing in asymmetry. Knowing this in advance allows for an asset-allocation rebalancing as the circumstances and probabilities change. In other words: reassess, reassess, reassess risks and rebalance, rebalance, rebalance.

Some of the discussion in our new book addresses these types of asymmetries. See Amazon.com, From Bear to Bull with ETFs or visit Cumberland’s website. In the book, we actually show the comparison with the ten sectors of the S&P 500 index and the relative performance of each sector in the bear and in the subsequent bull market.

Now let’s get to some potential shocks and comment about them:

  • Possible Shock Number 1: The Fed will cease “Operation Twist” on June 30. They confirmed the policy shift as recently as this last meeting and Bernanke’s statement. What will a twist cessation bring to bond yields? Will it change home mortgage interest rates? Delay a housing market recovery? Alter the steepness of the yield curve? Or the flatness of the yield curve? What happens to bond credit spreads? Pricing of repo collateral? Maybe the whole thing will pass as a non-event. Nobody knows.
  • Possible Shock Number 2:The so-called “fiscal cliff” is approaching at year-end. Strategas’ Dan Clifton and Jason Trennert have hammered this theme. Their summary identifies three elements:“… roughly one-third of the entire tax code expiring at the end of the year, the spending sequester beginning on January 2, a debt ceiling increase needed in the six weeks after the election and before the end of the year.”How much will markets anticipate these outcomes? How deep is fiscal drag? Is there a fiscal drag? Is Ricardian equivalence dead? How large is the policy shift danger to our country from the Congress? From this President? From next year’s President (re-elected or new)? All of these tax-spend-borrow outcomes are probable in the present-day realm of American politics. That puts our American destiny in the hands of a class of people who are very unpopular and despised by the majority of American citizens. Our politicians have become the scurrilous, scatological scoundrels that we elect and send to Washington. (We include both political parties in this opprobrium). Jack Bittner asks if we should limit all pols to a single term.
  • Possible Shock Number 3: The Bank of Japan has leaped to the top of the G4 central banks when it comes to balance-sheet expansion. BOJ announced an increase in the rate of asset purchases and an extension of the duration of the Japanese sovereign debt it will buy. Initial market reaction was that this plan is “not enough.” BOJ is trying to get Japan’s inflation rate UP! They have not succeeded in the past. Is this time different? What will be the impact on the foreign exchange markets? Will the yen weaken? If so, which currency will strengthen? We have written in the past that FX market adjustments are quite distorted when the G4 central banks are all maintaining their policy interest rates near zero.
  • Possible Shock Number 4:The FDIC limit on non-interest-bearing demand deposit insurance is scheduled to revert back to the pre-crisis level at the end of this year. We quote from the FDIC website:“From December 31, 2010 through December 31, 2012, at all FDIC-insured institutions, deposits held in non-interest-bearing transaction accounts will be fully insured regardless of the amount in the account. For more information, see the FDIC’s comprehensive guide, Your Insured Deposits.”What will be the impact in the money-market end of the yield curve? Will there be an extension of the termination date if markets begin to tighten? What will happen to repo rates? Repo collateral pricing? How closely is the Fed watching this development, since the Fed has been providing the market with more repo collateral (T-bills) through its Operation Twist? Is there a relationship, or will there be one? Can the banking system withstand larger withdrawals of zero-interest deposits if corporate agents deem deposits to be insecure without FDIC insurance coverage? (Note that the FDIC just closed five more banks this week. In the case of the Bank of Eastern Shore, Cambridge, Maryland, the FDIC has not found a buyer or merger partner, and the uninsured depositors are at risk of loss. Readers who are still worried about the safety of their bank deposits may check the FDIC website for the current rules).
  • Possible Shock Number 5: Watch the price and futures prices of Brent crude. Many are sanguine about oil and energy pricing and the gasoline price. We are not. Libyan production is not coming back in a hurry (hat tip to Barclays for superb research on the risk of Libyan civil war). Geopolitical risk is high in the Persian Gulf (Iran) and in Nigeria (see the developing news story of turmoil in this important oil-producing country). Worldwide demand for oil inexorably rises. U.S. energy policy still fails to accelerate our move to energy independence. Despite Energy Secretary Salazar’s protestations, the fact is that the Obama Administration has a failed energy policy and continues to pursue it. We do not drill, we do not encourage the use of natural gas in an accelerated and proactive way, and we do stymie new production and exploration. We do have pipelines running in the wrong directions, and we do have distorted domestic oil pricing because of excess inventories in Cushing, Oklahoma. At Cumberland, we remain attentive to this sector even as the market has become sanguine about it. We continue to hold our oil-energy-exploration and oil-service positions. The range of forecasts of the oil price is a mile wide. We have seen a low of $40 a barrel within two years and a high of $175. We lean to the higher price, not the lower one.

Reassess and Rebalance

I will stop now with the list of possible shocks and leave it to the reader’s imagination to complete this compendium with thoughts about Europe or China slowing or future inflation risk. Here is how we see the portfolio management decision. Remember this is today. It could change tomorrow, next week, next month or next year. The operative structure is reassess, reassess, reassess, rebalance, rebalance, rebalance.

Cumberland continues its fully invested approach using ETFs. We have been in that mode since the bear-market bottom of October 3. We think the bull market that started on October 3 is only half over as to price change and only one-third to one-fourth over as to time. Of course, any shock could derail this forecast. Our bond portfolios are slowly repositioning to a hedged or defensive mode. We have time. The process of moving from the present very low interest rates will require years and be volatile but gradual. Interest rates cannot go below zero. To get them above zero and into a more normal relationship, the G4 central banks must neutralize over four trillion dollars equivalent of excess reserves. Collectively they are still enlarging this position and are a long way from extraction from it.

Two items are recommended:

  • Read “Death of a Theory,” by St. Louis Fed president James Bullard, in the March-April/2012 monthly bulletin of that bank.
  • For analysis of last year’s bear market and the ensuing bull market, readers may wish to consult our new book, From Bear to Bull with ETFs. We thank readers for their responses so far. For the first time in our life, we have had a three-week-running best-selling book. All links to book distribution will be constantly updated on Cumberland’s website.

(Disclosure: The views and opinions expressed here are those of the author(s) and do not necessarily reflect the views of the Portfolioist. Cumberland Advisors is unaffiliated with FOLIOfn Investments.)

About David R. Kotok:

David R. Kotok co-founded Cumberland Advisors in 1973 and has been its Chief Investment Officer since inception. Mr. Kotok’s articles and financial commentary have appeared in The New York Times, The Wall Street Journal, Barron’s, and other publications. He is a frequent guest on financial television including Bloomberg Television, CNBC and Fox. He also contributes to radio networks such as NPR and media organizations like Bloomberg Radio, among others.

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Financial Literacy is the Issue of the Month? Try Issue of the Century.

April is Financial Literacy Month.

All month long, I have been trying to think of how to write a post that can express the depth of my conviction that the lack of financial knowledge is at the core of some of the biggest problems that we, as individuals (and as a nation) are facing.

There are so many areas in which we can see the enormous problems created by a lack of financial literacy that, frankly,  I don’t even know where to start. In fact, the Wall Street Journal just ran an article about college graduates who have little hope of ever being financially secure given their enormous levels of student loan debt. (Even President Obama isn’t exempt: he admitted today that he paid off his student loans just 8 years ago.)

This is a big problem. Continue reading